Reinvestment Rate

How to Calculate Reinvestment Rate

The expected growth rate in operating income is a byproduct of the reinvestment rate and the return on invested capital (ROIC).

• Reinvestment Rate → The proportion of NOPAT re-invested into capital expenditures (Capex) and net working capital (NWC).
• Return on Invested Capital (ROIC) → The profitability percentage earned by a company using its equity and debt capital.

The calculation of the rate of a company’s reinvestment is a three-step process:

1. First, we calculate net Capex, which is equal to capital expenditures minus depreciation.
2. Next, the change in net working capital (NWC) is added to the result from the prior step, representing the dollar amount of reinvestment.
3. Lastly, the value of the reinvestment is divided by the tax-affected EBIT, i.e. net operating profit after taxes (NOPAT).

Reinvestment Rate Formula

The formula for calculating the reinvestment rate is equal to the sum of net Capex and change in NWC, divided by NOPAT.

Where:

• Net Capital Expenditure (Capex) = Capex – Depreciation
• NOPAT = EBIT × (1 – Tax Rate %)

What is a Good Reinvestment Rate?

The change in NWC is considered a reinvestment because the metric captures the minimum amount of cash necessary to sustain operations.

• Increase in Net Working Capital (NWC) ➝ Less Free Cash Flow (FCF)
• Decrease in Net Working Capital (NWC) ➝ More Free Cash Flow (FCF)

Note that the net working capital (NWC) calculation includes only operating items, and thereby excludes cash and cash equivalents, as well as debt and any related interest-bearing liabilities.

Why? Neither cash nor debt are operating items.

How Do Reinvestment Rate Impact Expected EBIT Growth?

Once calculated, the expected growth in operating income (EBIT) can be calculated by multiplying the rate of reinvestment by the return on invested capital (ROIC).

In practice, a company’s implied rate of reinvestment can be compared to that of industry peers, as well as a company’s own historical rates.

Companies with higher reinvestment activity should exhibit higher operating profit growth – albeit, the growth might require time to realize.

If a company consistently has an above-market rate of reinvestment, yet its growth lags behind peers, the takeaway is that the capital allocation strategy of the management team could be suboptimal.

While increased spending by a company can drive future growth, the strategy behind where the capital is being spent is just as important.

A clear trend of reduced reinvestment, in contrast, could simply mean that the company is more mature, as reinvestment opportunities tend to decline in the later stages of a company’s life cycle.

Learn More → Reinvestment Rate and Growth by Industry (Damodaran)

Reinvestment Rate Calculator | Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Capex, Depreciation and Working Capital Assumptions

Suppose we’re tasked with calculating the reinvestment rate of a company using the following assumptions.

Financials (Year 1)

• Capex = $2 million
• Depreciation = $1.6 million
• Net Working Capital (NWC) = $800k

Financials (Year 2)

• Capex = $2.5 million
• Depreciation = $2.0 million
• Net Working Capital (NWC) = $840k

From the financials listed above, we can reasonably assume the company is relatively mature, given how depreciation as a percentage of Capex is 80%.

If the company were unprofitable at the operating income line, using the reinvestment rate is not going to be feasible.

2. Reinvestment Rate Calculation Example

The change in NWC is equal to –$40k, which represents a cash outflow (“use” of cash), as more cash is tied up in operations.

• Change in Net Working Capital (NWC) = $800k Prior Year NWC – $840k Current Year NWC
• Change in NWC = ($40k)

Since a negative change in NWC is a cash “outflow,” the -$40k increases the reinvestment needs of our company.

With the numerator complete, the final step before arriving at our company’s rate of reinvestment is calculating the tax-affected EBIT, or “NOPAT”.

Here, we assume our company had $20 million in EBIT for Year 2, which at a 25% tax rate, results in $15 million of NOPAT.

In closing, the reinvestment rate of our company is 3.6%, which we calculated by dividing the sum of the net Capex and the change in NWC by NOPAT.